An investor buys Coca-Cola (KO) today and it immediately drops 50%. The stock then stays at that 50% discount to the price he paid for 5-10 years. As a result, that investor becomes substantially richer in the long run.

The longer it stays undervalued the higher the long-term return.

What's going on?

Well, for starters, this works best when:

The investment horizon that is at least 5-10 years and ideally even longer

Comfortably financed businesses (strong balance sheet/lots of liquidity) with ample free cash flow and high return on capital are purchased

Shares are bought below (ideally well below) intrinsic value

Now, I realize the above investor would feel pretty unlucky for having bought at a price so much higher than what became available soon after. I know persistently undervalued shares will increase my long-term returns yet it's still not easy to see a stock that was just purchased go down in price.

Loss aversion is a powerful force that's difficult to manage even when you are aware of it.

So, even with a decent understanding of loss aversion, my initial instinctive response to a price drop after purchase is sometimes still negative but, over time, it's been possible to develop a trained more rational response.

To celebrate.

Naturally, in the long run, an investor wants the shares that were bought to be materially higher. Yet, unless a shareholder intends to sell shares soon, a drop in price* in the near to intermediate term works to the investor's advantage.

A persistently cheap stock price relative to value allows a larger percentage of the shares outstanding to be bought with the company's own cash flow from operations over time (or via cash on the balance sheet and, in some cases, debt issuance).

The math, of course, is simple.

A 50% drop in price may be terrible to stare at on a computer screen or monthly statement, but it allows 2x as many shares to be bought back with the same amount of dollars. Do that consistently over time and it creates a ton of wealth for remaining long-term shareholders.

Let's say shares of a good business are bought at 10x free cash flow and the shares then drop 50%.

In that situation, even if the earnings do not grow, share count would be reduced by 50% over two and a half years using just free cash flow (even if free cash flow shrunk somewhat the returns are clearly very favorable for the owners that hang on for the long haul).

The key again is that the shares are, in fact, being bought below intrinsic value. Too often with buybacks that is not the case. Using a company's dividend to buy more shares when selling below intrinsic value can accomplish a similar thing.**

The difference in returns is not academic. Consider the case of Philip Morris where $ 10,000 invested in 1957 grew to roughly $ 80 million over 50 years. Philip Morris shareholders had frequent undervaluation and, of course, the durable superior core economics of the business itself working for them over those years.

This works best for well-financed (strong balance sheet, lots of liquidity) businesses with durable core economics that can reliably produce far more capital than it ever needs to run the business. Those with superior economics and durable competitive advantages are the best candidates.***

Interestingly, even though Coca-Cola has been a great investment over the past twenty years, one of the reasons the stock did not perform as well as it would have otherwise was its extremely high valuation in the 1990s (particularly the late 1990s). It became way overvalued and stayed that way for years. This prevented Coca-Cola management from reducing shares outstanding on the cheap.

The bad news is that the stock of quality businesses like Coca-Cola do not often sell at a large discount to value. The good news is even a slightly undervalued stock price bought back consistently can make a meaningful difference over time.

Naturally, when someone buys a stock they want to see it go up but that high price actually does reduce long-term returns. Seeing a stock sell below the price paid for an extended period is difficult for some investors to tolerate. Quite a few end up bailing out before the benefits of shares bought at cheap prices has really had an impact.

Shares of a good business bought consistently below intrinsic value has powerful long-term effects. This works whether it is the individual investor (through additional share purchases or dividend reinvestment) or the company itself that is doing the buying.

None of this works, of course, if value is misjudged or shares of what turns out to be a lousy business were purchased.

Also, the investor must have a truly long-term investing horizon.

Otherwise, it just isn't very likely to work out all that well.

Adam

* Of course, eventually an investor wants the stock to go up. It's just that an investor is better off if market participants misjudge intrinsic value on the low side for as long as possible. It only matters if the investor decides to sell many years later. Until a stock is sold ideally many years down the road, a low price, even if it sells below the price paid for an extended period, is in fact an advantage. What's an exception to this? Here's one scenario to consider. Unfortunately, there's the very real risk that a buyout offer comes in at a premium to market value but a discount to intrinsic value. If enough owners are okay with the gain that will have occurred compared to the recent price action, the deal may be approved. If too few have conviction about longer run prospects, the deal may get approved. When too many owners of shares are in it for the short-term or, at least, primarily to profit from price action, the chance of this happening increases. Well, those that became owners because of the plain discount to intrinsic value and the company's long run prospects will likely get hurt in this scenario.** Economically a stock buyback vs dividend re-investment would be the same thing but there is a difference from a tax standpoint. Naturally, one has to pay taxes on those dividends. So, if management is a good capital allocator (a big if), the investors are better off if the company buys back the shares directly.*** First and foremost, the amount of capital required to run the business and how much the free cash flow generation can grow over time are the crucial factors in long-term value creation. After that it comes down to how well management allocates capital.---This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.